The Great Balancing Act: US on the high wire

High Wire ActThe previous post was, in essence, a set up for this one.  Those looking for illustrative examples of radical economic philosophy will find none better than the musings of Nevada Representatives Amodei (R-NV2) and Heck (R-NV3).   When radical economics combine with radical politics the resulting admixture is toxic, and dysfunctional.  Witness the 12% approval rating for the Congress. [HuffPo]

So, why is the economic theorizing beloved by our two Tea Party darlings from the Silver State to be categorized as “radical?”

#1. It turns classical economic theory on its head.  Traditional economic theory asserts that an equilibrium price, and optimal market function,  can be determined when supply and demand for goods or services converge.  To give undue attention to one side or the other of the equation is asking for trouble.  Since the perpetration of the Supply Side Hoax, the “job creators” (corporate executives) have been attended to like medieval monarchs, with the Congress bowing, scraping, and otherwise engaging in obsequious behavior before members of the CEO class.   In sum, the Supply Side economics offered by the radical Republicans of the 21st century is little more than a political agenda masquerading as an economic theory. (1)

#2.  It eviscerates the guiding principal set forth in the founding documents of this nation which contends that we do better as a country when we take an interest in our communal welfare, and economic interests.  The preamble to the U.S. constitution notes that one of our foundational principles is the notion we should “promote the general welfare,” not that we should promote the interests of the rentier class, or any other specific class for that matter.  One of the first charges leveled at King George III was that he had “refused his asset to laws, the most wholesome and necessary for the public good.”  (Declaration of Independence) Note that the criticism wasn’t that the monarch had not attended to the good of “some” but of “all.”

In order to make this country work politically, as well as economically, we need to balance the needs and interests of business and labor.  Capital and commerce. Consumers and manufacturers.  When things get out of balance, things go wrong.  Achieving a balance between competing interest demands compromise.  However, when the Republicans in Congress assert their demand that they will not enact any modifications to the debt limit until the President and the Democrats in the Senate agree to repeal the Affordable Care Act and Patients Bill of Rights, accept the Ryan Budget, and privatize Medicare — the unwillingness to compromise produces nothing but manufactured gridlock.  Those who advocate no comprise in the face of opposition to their own exclusive agenda are functioning as anarchists — promoting no government as a solution to any governance.  (2)

Radical Theory Applied to Practical Reality Yields Poor Results

I’ve lost count of the number of times I’ve used the term “aggregate demand” in economic related posts.  However, when the situation becomes unbalanced and the needs of the top 1% of the American public are given greater consideration than those of the other 99% we have a situation in which there are few positive long term results.

Unalleviated promotion of the demands of the 1%, especially in the financial sector, helps to create economic consequences such as an increase in income disparity.  This is NOT to argue for some scheme of income re-distribution imposed by the federal government, but for a market based re-distribution based on the traditionally accepted principles of standard economics — including attention to the necessity of increasing our aggregate demand.

Increasing income disparity means that fewer households control more wealth, and hence have more spending “power.”  It is possible to have a warehouse load of vehicles, BUT the U.S. annually  manufactures some 15,797,864 cars and trucks (as of 2012) [WardsAuto  XL download] and 1% of the population obviously isn’t going to make a dent in this inventory without some significant assistance from the middle class.   The American middle class is less able to contribute to the aggregate demand than it was prior to the last Recession:

“Median household income in the country is nearly $4,000 less than what is was back in 1999. Things have gone from great to terrible since then, and this change has certainly played out in the nation’s median household income number. In September of 1999, the national unemployment rate was 4.2%; in September of 2011, the national unemployment rate was 9.1%.” [Manuel.com]

There are all manner of explanations for this situation, from various positions on the political spectrum.  For the radical right the explanation is to be found in the “high” corporate tax rates and regulation of financial transactions (the politics of prosperity for some and austerity for all).  For the left the explanation often incorporates the nefarious influence of the 1%.  Easy rationalizations miss an essential question.

What does our allocation of interest, energy, and resources tell us about our attention to our economic health?

There is one sector of our economy which has experienced significant growth — finance.  The NBER published a paper in 2007 offering an explanation for this increase:

“The share of finance in U.S. GDP has been multiplied by more than three over the postwar period. I argue, using evidence and theory, that corporate finance is a key factor behind this evolution. Inside the finance industry, credit intermediation and corporate finance are more important than globalization, increased trading, or the development of mutual funds for explaining the trend. In the non financial sector, firms with low cash flows account for a growing share of total investment. […] I find that corporate demand is the main contributor to the growth of the finance industry, but also that efficiency gains in finance have been important to limit credit rationing. Overall, the model can account for a bit more than half of the financial sector’s growth.”  (emphasis added)

Some definitions are in order, for example what’s “credit intermediation?”   The simplest way to describe this is to say that intermediation is the transfer of funds from the ultimate source to the ultimate user.   Our banks “intermediate credit” when they borrow from depositors to make loans to creditors.

Corporate finance runs a gamut of fiscal operations.  However, the standard expression relates to how does a corporation manage its capital investment decisions?  Decisions would be made such as should the company raise funds by the equities route, by issuing debt (bonds), and so forth.

If the NBER report is essentially correct, then the increasing transfers of funds, and the increasing role of corporate finance transactions are driving the increase in the growth of the financial sector.  So what?

The “so what” question may be answered, at least in part, by observing the increasing role of securitization of assets (Remember: One man’s debt is another man’s asset), and manufacturing of financial products in the “intermediation” process.   There’s a cautionary note from a 2009 IMF report (pdf)

“Mobilizing illiquid assets and transferring credit risk away from the banking system to a more diversified set of holders continues to be an important objective of securitization, and the structuring technology in which different tranches are sold to various investors is meant to help to more finely tailor the distribution of risks and returns to potential end investors. However, this “originate-and-distribute” securitization model failed to adequately redistribute credit risks, in part due to misdirected incentives. Hence, it is important in restart ing securitization to strike the right balance between allowing financial intermediaries to benefit from securitization and protecting the financial system from instability that may arise if the origination and monitoring of loans is not based on sound principles.”

What the polite phrasing of the IMF document is trying to say may very well be — “all the fancy ways the investment houses tried to reduce the risk to investors in various schemes aren’t going to be much help IF the underlying assets aren’t very good in the first place.” So, why did the system freeze up in 2007-2008?  Insert “avarice,” or good old fashioned “greed” in the place of “misdirected incentives,” and we have a situation in which all the financial products dreamed up by the “market makers” couldn’t erase the hard cold fact that many of the mortgages and other credit instruments which were securitized into ever more elaborate packages weren’t any good in the first place.

If we’re spending too much of our attention, energy, and finances on manufacturing financial products which are supposed to spin dross into gold for investment houses and major banks,  then we’re not paying attention to the sectors of our economy which need more attention, more energy, and more financing.

All analogies break down at some point, but for illustrative purposes only contemplate what might happen to an individual who owns a home with a set of broken steps to the front porch.  These steps are a risk for the homeowner.  However, instead of fixing the broken stairs the homeowner buys an extra insurance policy to offset his risk, then the benefits of the policy may be securitized, the security may be further offset with hedges, bets, and other derivatives — and in all the revenues generated and all the fees and commissions collected everyone appears to forget that the entire financial contraption is built upon a set of broken stairs.   When the steps collapse, as they inevitably must, the policy must pay out, along with those who bet against the policy being paid out and those who bet on the policy in favor of the  benefits being paid…. and so it might go.

The moral of this hypothetical is that if we are paying more attention to devising ways to mitigate risk, and manufacturing more financial products to do so, and we are not attending to correcting the faulty underlying assets — then we ought not complain when the house of cards falls in a heap at our feet.

Further, if we are studiously attending to generating revenue from the transfer of risk among credit intermediaries and corporate finance offices, then we are consequently paying less attention to our education system, our infrastructure, our manufacturing and business lending operations, and our fundamental  banking soundness.  Further, as more finance is sucked into the Shadow Banking system, the very real one is in danger of being neglected.

Worse still, according to the Economic Policy Review, the emphasis on the shadow system isn’t leveling off:

“Looking ahead, the authors contend that despite efforts to address the excesses of credit bubbles, the shadow banking system will likely continue to play a significant role in the financial system for the foreseeable future. Furthermore, increased capital and liquidity standards for traditional banking entities are “likely to increase the returns to shadow banking activity” partially because reform efforts have done “little to address the tendency of large institutional cash pools to form outside the banking system.”

This really doesn’t give much hope that financial institutions and major corporations will be excited about investments in manufacturing, infrastructure, or work force concerns, at least not in the foreseeable future.

Increasing aggregate demand, and thereby increasing our GDP, requires more earning power in the wallets of more residents and citizens.  The shadow banking system is not designed to take into consideration the credit needs of American car buyers — only to securitize and minimize (and then bet on) the credit worthiness of the underlying loans.   If banks made “good” home and auto loans then there would be less need to offset risks — which need not stop the shadow system from continuing to bet on the prospects of default anyway.

Finance and The Family Wallet

Looking back at the mess created by the Mortgage Meltdown of ’08, several observers were wont to ask — Why did the banks make those shaky loans in the first place?  And, no, it wasn’t because they “had to” because of the consumer finance laws — they made them because the loans could be originated quickly then securitized even faster. Once securitized the financial sector could manufacture  products to paper over the risks to the bankers — here came the hedges, bets, derivatives, swaps, etc. — and if the revenue generated from the manufacturing of those paper products could be greater than the loss from the loan default — then where was the incentive to make good and proper loans?  Someone wasn’t looking at those faulty front porch steps?

That was then, this is now and those who are playing derivative games with the underlying assets originally residing the family wallet aren’t taking kindly to being regulated, to being required to be more transparent, to being litigated against because of their manipulations.  Some more attention needs to be paid to that crucial line from the IMF report: “Hence, it is important in restarting securitization to strike the right balance between allowing financial intermediaries to benefit from securitization and protecting the financial system from instability that may arise if the origination and monitoring of loans is not based on sound principles.”

Balance

There’s that word again — we need some balance between competing interests (capital and commerce, labor and ownership) and balance requires — demands — compromise.  Those standing on the ramparts of their own idiosyncratic battlements of ideological purity, refusing to compromise with the dreaded Other, are jeopardizing not only the political life of this nation but the economy of the country as well.

(1) For more on this topic see: The Trickle Down Hoax, AmericanThinker, July 15, 2012.  The Political Genius of Supply Side Economics, Financial Times, July 25, 2010. (registration required) Supply Side Economics Explained, Reign of Error, September 23, 2005.  The Six Biggest Hoaxes in History, Huffington Post, May 23, 2013.

(2)  See also: Gridlock and Harsh Consequences, New York Times, July 7, 2013.  Gridlock in Congress, CNN, May 21, 2012.  Five Reasons Gridlock Will Seize Congress Again, Washington Post, January 4, 2013.   Congress Shows Few Signs of Ending Gridlock, Bloomberg News, July 8, 2013.

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